Dovetailing Interests: The Key to Unlocking Hidden Value in M&A Deals

Written by CMPartners Principal, Rob Rosen

dovetail /ˈdʌvˌteɪl/ verb: to fit together conveniently

In my roughly 20 years as a private equity dealmaker, I had my share of successful negotiations and also conducted many that ended disappointingly. Upon reflection, I realize that I could have achieved far better outcomes had I focused my efforts differently; instead of only searching for common ground, I could have looked for areas of difference between my counterpart and me. Perhaps counterintuitively, that is where I could have created more valuable deals.

Years ago, my business partner and I were pursuing the acquisition of a highly successful consumer products manufacturer. We were concerned about the topic of company valuation, as we knew that the success of the company hinged largely on the founder/owner/CEO and his extensive relationships in the retail trade. At one point during our first meeting, the owner told us that he had taken $28 million of distributions from the company since its inception a few years earlier. He told us this to impress us with the company’s ability to generate cash; however, our first thought was: “This company would be a lot more valuable if he had reinvested that money in the company’s growth.”

In a later meeting, as we began to negotiate the company’s valuation, the owner conveyed to us that he expected a valuation based on a fair multiple of the company’s earnings, normally a reasonable approach. My partner blurted out “We’re not paying you that – you’ve already realized the value of your company through the money you’ve taken out over the last few years. We’ll offer you a contingency payment based on how well the company performs in the first two years after the closing.” Needless to say, that effectively killed the negotiation. We learned later that another investor had agreed to the owner’s request and had done quite well with the investment.

Why was another investor willing to do a deal we thought was too risky? How did they get comfortable with a deal structure that we thought to be imprudent? Let’s take a look at the dynamic that doomed our deal and then at another approach that could have facilitated it.

A Myopic Focus on Our Primary Interest Versus An Expansive Consideration of All Interests

My partner and I were deeply concerned about the sustainability of the company’s impressive financial performance. If the owner had taken $28 million in distributions, what would prevent him from leaving the company and enjoying a well-earned retirement? How could the company sustain and grow its business if the owner left? To us, the only way to protect ourselves and our investors was to make the entire consideration contingent on his remaining with the company and on its continued success. In short, the sole focus of our negotiation strategy was our fear that he might leave the company.

Although we had a valid concern, we failed in at least one important way: we allowed it to become the only concern – or interest – that we considered. Our thought process was: we have a concern, we know of a solution to address the concern, and therefore we will insist on that solution. In retrospect, it was a simplistic and inadequate approach to the problem.

A challenge for my partner and me – and for many dealmakers – was time and attention: there was a limited amount of time in the day, there were several deals on our plate, and we needed to either move this deal forward or walk away and focus on the ones that have a better chance of closing. Sound familiar?

The flaw in this logic is that we don’t just want to get deals done, we want to get good deals done. Sometimes we choose the wrong deals from which to walk away, the deals that will provide the most attractive returns. With a different approach, we can close those deals – the ones that have tricky issues to address but ultimately will make the most successful investments.

How could my partner and I have approached this deal differently? The investor that ultimately was able to acquire the company considered not only its interests but also the interests of the owner. By doing so, the other investor was able to craft a deal that satisfied its interest in having the owner stay at the company, actively engaged in growing it profitably. The key to this deal – and many deals – is dovetailing interests.

Dovetailing interests, as the name implies, are interests that fit together well. If you have an interest that is important to you (say, for example, securing the enthusiastic involvement of the owner post-closing), an effective way to have that interest met is by dovetailing it – putting it together – with an interest that the owner has. For example, the owner may still be interested in growing the business but may also have a strong interest in devoting time and resources to a particular charitable organization. Perhaps a solution might be that the owner stay at the company on post-closing, with primary responsibility – and economic incentives – for sales growth; in exchange, a certain percentage of all new company sales will be donated to that charitable organization and the owner can take a certain number of ‘charitable work leave days’ each year. That way, the investor gets what he wants (greater certainty of the owner’s ongoing engagement) and the owner gets what he wants (involvement with the business but also more time and resources to devote to his favorite charity).

The key to the successful use of dovetailing interests is finding an interest that one party holds quite dear but to which the other party is relatively indifferent and matching that with another interest to which the first party is relatively indifferent but which the other party holds quite dear. In that way, the ‘give’ by each party is painless relative to the ‘gain’ each receives.

In an environment where efficiency is of paramount importance, the easy route is the one my partner and I took on the consumer products deal: a take-it-or-leave-it proposition. Yet we ended up walking away from an investment that would have done very well had we been more patient and creative in exploring dovetailing interests; by focusing more strategically on potential dovetailing interests, dealmakers can address these thorny issues in deals that are otherwise highly attractive and additive to their portfolios.